Dynamic asymmetry of exchange rates, interest rate differentials and currency crash risk

Abstract

In this paper, we propose an unified econometric strategy to revisit the predictive content
of interest rates for exchange rate returns. The novelty of our approach is to take into account dependencies of higher orders by allowing for a time-varying asymmetry component
in the distribution of exchange rates, therefore explicitly modeling the effect of interest
rates on extreme events. Using daily data on USD/EUR currency pair over the period
1999-2019, we find the dynamic asymmetry component to be significant and driven by
interest rate differentials, but also by general uncertainty and past unexpected shocks. In
line with recent currency crash theories, our study suggests that the larger the difference
between interest rates, the more likely the high yield currency is to appreciate but also to
experience currency crashes. To assess the economic significance of our results, we introduce a directional forecasting approach derived from our model. We show that a trading
rule based on these forecasts provides better in-sample and out-of-sample economic performance compared to benchmark models.

Keywords: Exchange rate, interest rate differential, asymmetry, GARCH, currency crash

JEL Classification: F31, C53, C58